Ms. Kim Hekker
Technical Manager
Accounting Standards, File 3162.LD
American Institute of Certified Public Accountants
1211 Avenue of the Americas
New York, NY 10036-8775
Proposed Statement of Position: Accounting and Reporting by Insurance
Enterprises for Certain Nontraditional Long-Duration Contracts and for
Separate Accounts
Dear Ms. Hekker:
The American Academy of Actuariesâ&#x20AC;&#x2122; (Academy) Life Financial Reporting Committee
(LFRC) is pleased to have this opportunity to comment on the exposure draft of the
proposed Statement of Position (SOP): Accounting and Reporting by Insurance
Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate
Accounts. We commend the Nontraditional Long-Duration Contracts Task Force (Task
Force) for a very thoughtful proposal, and we appreciate the opportunity for Academy
liaisons to participate in the Task Forceâ&#x20AC;&#x2122;s deliberations and drafting process.
In general, we are very supportive of the draft SOP. In this letter, we will generally limit
our comments to certain of the conclusions that we find problematic or in need of further
clarification.

Issue 5: Return Based on a Contractually Referenced Pool of Assets or Index
We would like a clarification that this provision applies only to general account business.

Issue 6: Annuitization Options
We disagree with the conclusion that no liability should be established during the
accumulation phase related to the potential costs of annuitization incentives (defined as
contract provisions that provide favorable treatment at annuitization via rights defined
within the issued contract).

Our main concern is that in many instances this conclusion will result in an accounting
treatment that does not appropriately reflect the economics of the product. Ignoring
certain types of annuitization incentives could impede the fair presentation of liabilities
and result in a distorted and aggressive pattern of earnings such as gains during the
accumulation phase followed by potentially large losses or significantly reduced margins
during the annuitization phase of the contract.
Examples of benefit designs that may exhibit such earnings patterns include: (1) two-tier
annuities, which provide an upper tier account value that is only accessible for purposes
of annuitization, and (2) guaranteed minimum income benefits on variable annuities,
which depending upon separate account performance may provide similarly large
economic benefits to policyholders that elect to annuitize the contract.
Attachments A1 through A4 provide sample illustrations of the earnings patterns that
would result under the proposed SOP for the following types of situations:
Attachment
A1
A2
A3
A4

Product Type
GMIB
GMIB
Two-Tier
Two-Tier

Payout Type
Lifetime Income
Period Certain
Lifetime Income
Period Certain

A1 and A3 show the earnings pattern for an annuitization benefit that contains a
significant mortality component, with the annuitization phase being reserved for as a
Financial Accounting Statement (FAS) 97 limited pay contract subject to loss recognition
at the point of annuitization. A2 and A4 show the earnings pattern for an annuitization
benefit without a mortality component, with the annuitization phase being reserved for as
a FAS 91 investment contract. As can be seen in the examples, a loss at annuitization
occurs in the first case, and losses throughout the annuitization period occur in the second
case. An additional reserve for annuitization incentives accrued during the accumulation
phase of the contract would prevent either of these problematic earnings patterns.
We believe it is inappropriate to fail to recognize the anticipated costs of such
annuitization incentives during the accumulation phase of the contract. The conclusion
not to recognize such costs appears to be at odds with various fundamental principles of
Generally Accepted Accounting Principles (GAAP) accounting â&#x20AC;&#x201C; including the definition
of a liability (probable and estimable), the matching principle, the concept of unearned
revenue, and the concept of loss recognition that applies to insurance contracts.

2

Paragraph A22 indicates that annuitization benefits are not part of the accumulation phase
of the contract. For contracts with significant annuitization incentives, we believe the
distinction is not clear. The annuitization incentive may be viewed as a persistency
bonus that is funded by revenues earned during the accumulation phase and serves as a
bridge between the accumulation and payout phase of the contract. From this
perspective, an annuitization incentive is integral to and should be recognized during the
accumulation phase of the contract. In the case of Guaranteed Minimum Income Benefits
(GMIBs) on variable annuities, there are generally explicit revenue charges assessed
during the accumulation phase.
Paragraph A28 indicates that an annuitization guarantee is a price risk. This may be so
for the minimum purchase rate guarantees on traditional annuity products (e.g., a 3
percent guarantee when prevailing settlement rates are 5 percent). On some products,
however, the annuitization incentive is more than a price risk, it is an integral design
element and a policyholder benefit with significant expected value when the policy is
issued. Unlike traditional annuities, where the annuitization option is not heavily
utilized, contracts with strong annuitization incentives generally do experience significant
annuitization activity. We believe the cost of annuitization incentives, where significant,
should be recognized during the accumulation phase when the associated revenues
(whether implicit or explicit) are earned.
We note that the conclusion in FAS 97 indicating that the annuitization phase should be
treated as a separate contract was premised on the fact that when FAS 97 was issued
annuitization guarantees were generally of limited value, annuitization activity was rare,
and the annuitization transaction itself was essentially priced for as a new sale that occurs
at fair value. For certain contracts offered today with significant annuitization incentives,
none of these underlying premises hold true.
In paragraph A30, the Task Force expresses concerns about the definition and
measurement of the extra cost associated with annuitization bonuses. We believe it is
possible and reasonable to define and measure the cost of such bonuses by comparing the
present value of annuitization benefits, discounted using the portfolio earned rate less a
suitable margin for profit and adverse deviation, to the greatest of the amounts available
in cash (the benefit reserve under the proposed SOP).
In our view, it would be appropriate to accrue an additional reserve for the extra benefit
costs arising from the annuitization incentives, with appropriate adjustments for expected
persistency and utilization of the annuitization benefit. In other respects, the reserving
for annuitization incentives could parallel that proposed by the SOP for persistency
bonuses. In the case of GMIBs, the reserving mechanism should parallel the proposed
reserving for Guaranteed Minimum Death Benefits (GMDBs). In the traditional deferred
annuity case contemplated in FAS 97, the extra cost would be at or near zero since the
present value of the annuitization benefits would approximate the amounts available in
cash and expected annuitization rates would be low. Note that the annuitization itself
would continue to be accounted for as a separate contract as indicated by FAS 97.

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Issue 7: Accounting for Contracts That Contain Death or Other Insurance Benefit
Features
I. Mortality Significance
We believe the guidance relating to the determination of the significance of mortality risk
is too restrictive. The SOP refers to the present value of expected excess payments in
relation to the present value of revenue. We have two concerns. First, focusing on the
expected results does not allow for appropriate consideration of significant risks in the
“tail” of the loss distribution – i.e., low probably but high severity losses as found in
some variable annuity and other contracts. Low probability, high severity risks are the
essence of insurance risk and should be taken into consideration when determining
whether mortality or morbidity risk is significant. Second, we also note that using
present values in the determination of mortality risk could inappropriately underweight
the consideration of risks that arise in the later years of a policy.
We believe the determination of whether there is significant mortality or morbidity risk
should reflect a broader range of considerations than just the expected present values of
excess claims and revenues. In our view, the SOP should allow for consideration of low
frequency, high severity risks as well as consideration of both discounted and
undiscounted amounts.
II. Scope of Benefits Covered
Paragraph 26 of the draft SOP establishes an additional liability in situations where the
amounts assessed in a period are not proportionate to the insurance coverage. Without
further clarification and refinement, however, we believe the proposed SOP could
unintentionally sweep in certain products and coverages and thereby require substantial
unintended changes to current accounting.
Part of our concern with the SOP as drafted relates to the terms “proportionate” and
“insurance coverage.” Many Universal Life (UL) and Variable Universal Life (VUL)
products have expected mortality costs that increase over time as a percentage of the cost
of insurance charges (e.g., 50 percent grading to 90 percent). Typically, the decline in the
mortality margin is offset by an increase in the interest margin such that the overall profit
emergence is not unreasonable. Should an additional reserve be established so that
mortality costs are directly proportionate to the insurance charges? We think this goes
beyond the intent of the draft SOP, and FAS 97 already addresses situations involving
excess front-end loads that are intended to compensate the insurer for benefits or services
to be provided in future periods.

4

On the other hand, FAS 97 does not appropriately address the treatment of VUL plans
with GMDB provisions. Variable universal life plans generally have GMDBs in the form
of a no-lapse guarantee, i.e., contract is guaranteed to stay in force provided that
minimum specified premiums are paid, even when the account value is depleted and the
contract would otherwise lapse. Some VUL contracts have GMDB periods that extend
for many years into the future. As the amounts assessed are generally not proportionate
to coverage in periods where the GMDB comes into play, we believe that, if material, it
would be appropriate to establish a reserve analogous to the reserve for GMDBs on
variable annuities. In the case of VUL GMDBs, the excess benefits should be defined as
the expected charges waived â&#x20AC;&#x201C; i.e., the cost of insurance and expenses charges net of the
premiums required to keep the contract in force during the period when the policy would
otherwise lapse in the absence of a GMDB feature.
As the SOP is currently written, to reserve for a VUL GMDB it appears necessary to
reserve for all benefits in excess of the account value, not just the GMDBs; this could
radically change the recognition of mortality margins, which does not appear to be
appropriate or the intent of the SOP.
Similar issues exist with universal life policies that contain no lapse guarantees.
We believe the potential unintended consequences of the draft SOP can be avoided by
defining the scope of the additional liability requirements to apply to only those benefits,
or portions thereof, that are deemed inherently non-periodic, i.e. are expected to be zero
or insignificant in most periods but become significant under periods of specific
economic conditions. In the case of a no-lapse guarantee, this benefit represents a partial
waiver of assessments to the extent the account value plus premium are inadequate to
fully cover the cost of insurance and other fund fees and charges. The waiver benefit
would be considered non-periodic as it would be zero in most periods but there are
economic scenarios where substantial benefits may arise, and would thus be subject to an
additional liability. The base death benefits are periodic in nature with charges that are
generally proportionate to the risk and would thus not be subject to any change in
accounting.
III.

Amortization of the Additional Liability

We believe the cost of excess benefits should be recognized in proportion to gross profits
using the same methodology used for Deferred Acquisition Costs (DAC). Nonproportionate benefits would be excluded from gross profits consistent with the exclusion
of all other non-level type items, i.e., acquisition costs, excess front-end loads, and sales
inducements. This would result in the same estimated gross profit stream being used for
amortizing all non-level items, i.e., DAC, unearned revenue, sales inducements and nonperiodic benefits. Besides ensuring consistency, the calculations could be more readily
done because they would follow established procedures for amortizing DAC and
unearned revenue.

5

This proposed method would also solve some other technical problems that we have
noted with the method described in the draft SOP. These problems are enumerated in
Attachment A5.
Finally, the provision that the additional liability not be less than zero is appropriate.
Although not specified in the draft SOP, our view is that, consistent with IAS groupings,
this is appropriately applied at an aggregate grouping level.

Issues 9 & 10: Sales Inducements to Contract Holders
We agree with conclusions reached in the draft SOP regarding sales inducements to
contract holders. Upon close review, we propose a small modification to the wording in
Paragragh 33.
Paragraph 33 states that “…The insurance enterprise should demonstrate that such
amounts are (a) incremental to amounts the enterprise credits on similar contracts without
sales inducements…”. We suggest adding the underlined wording to this paragraph:
“…The insurance enterprise should demonstrate that such amounts are (a)
incremental to amounts the enterprise credits or would credit on similar contracts
without sales inducements…”.
This additional wording is needed because companies may not have a similar product in
their portfolio that does not have a sales inducement.
In closing, we again want to thank the American Institute of Certified Public Accountants
for the opportunity to share our views on the proposed SOP. If you have any questions,
or need additional clarification, please contact Steve English, the Academy’s life
insurance policy analyst (202-785-7880, english@actuary.org) or me (312-879-2122,
michael.hughes@ey.com).
Sincerely,

************
The American Academy of Actuaries is the public policy organization for actuaries
practicing in all specialties within the United States. A major purpose of the Academy is
to act as the public information organization for the profession. The Academy is nonpartisan and assists the public policy process through the presentation of clear and
objective actuarial analysis. The Academy regularly prepares testimony for Congress,
provides information to federal elected officials, comments on proposed federal
regulations, and works closely with state officials on issues related to insurance. The
Academy also develops and upholds actuarial standards of conduct, qualification and
practice and the Code of Professional Conduct for all actuaries practicing in the United
States.

Payout begins after 5 years
Payout period is lifetime payout with 5 year period certain
Annual payout based on the GMIB rollup of $127,628 is $14,400

Income Statement Results
Because there is a loss at annuitization, loss recognition requires setting
a reserve so that no gains or losses are expected.
At annuitization, a yield rate of 6% is locked in for annuitization

Payout begins after 5 years; payout option is 5 year period certain
Payout interest rate is 5%
Annual payout based on the GMIB rollup of $127,628 is $29,479

Income Statement Results
The interest rate that equates $116,939 with a payout of $29,479 is 8.25%
Therefore valuation interest rate during payout is 8.25%
At annuitization, yield rate of 6% is locked in for annuitization period

Note: this example assumed that loss recognition is taken point of
annuitization on an individual policy basis. In practice, loss recognition
would be considered on a book of business basis.

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Attachment A4
Two Tier Annuity
Period Certain Annuitization
Assumptions:
Interest accrues to the lower "cash" tier at guaranteed rate of 3%
Interest accrues to the upper "annuitization" tier at current rate of 5%
Earned interest rate is 6% all years
Ignore DAC impact on earnings

Year
0
1
2
3
4
5

Lower
Tier
Accum
100,000
103,000
106,090
109,273
112,551
115,927

Upper
Tier
Accum
100,000
105,000
110,250
115,763
121,551
127,628

Payout begins after 5 years; payout option is 5 year period certain
Payout interest rate is 5%
Annual payout based on the upper tier value of $127,628 is $29,479

Income Statement Results
The interest rate that equates $115,927 with a payout of $29.479 is 8.58%
Therefore valuation interest rate during payout is 8.58%

Attachment 5
Non-periodic Benefits
Draft SOP Methodology for Additional Liability
To recap, the method proposed in the draft SOP for handling non-periodic benefits is to
establish a liability such that the incurred benefits are reported as a level percent of the
total assessments stream. This calculation is periodically unlocked to reflect actual
experience and revised expected experience. The benefits net of changes in their
liability, including unlocks, are fed into the gross profits stream used for DAC and
unearned revenue. Following are certain technical issues with this method:
1. There is a circularity of calculation. Paragraph 26 notes:
â&#x20AC;&#x153;For contracts in which the assessments are collected over a period shorter than
the period for which the contract is subject to mortality and morbidity risk, the
assessment would be considered a front-end fee under FASB Statement No. 97
and accounted for under paragraph 20 of Statement No. 97. The amounts
recognized in income should be considered assessments for purposes of this
paragraph.â&#x20AC;?
This leads to non-level assessments being deferred in proportion to gross profits that are
dependent on changes in the non-proportionate benefits liability that is in turn dependent
on changes in the non-level assessments, resulting in a circular calculation.
2. In order to maintain internal consistency, it can be mathematically demonstrated that
it is necessary to deduct a component of interest earned from the changes in liability
when calculating gross profits (if one wants to assure projected net profits maintain
proportionality to gross profits under the assumption of earned interest rates equal to
credited rates). This would further complicate the calculations.
The alternate method proposed by Academy addresses the above issues. In particular,
the various non-proportionate items are removed from the gross profit stream; therefore
a change in any one of these would not impact the gross profit stream and would
thereby avoid requiring an unlocking in the other items.